Videos: Credit Default Swaps – the next crisis?

These two videos attracted my interest. Have you heard of Credit Default Swaps? If not, read (watch) on…

Part 2.

There’s more on Wikipedia, too. So what is a Credit Default Swap?

"A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby one makes periodic payments to the other and receives the promise of a payoff if a third party defaults. The former party receives credit protection and is said to be the "buyer" while the other party provides credit protection and is said to be the "seller". The third party is known as the "reference entity".

When a credit event in the reference entity is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery amount of the bond (cash settlement). Simply, the risk of default is transferred from the buyer to the seller.

For example, ABC Corporation may have its credit default swaps currently trading at 265 basis points (bp). In other words, the annual cost to insure 10 million euros of its debt would be 265,000 euros. If the same CDS had been trading at 7 bp a year before, it would indicate that markets now view ABC as facing a greater risk of default on its obligations.

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events (such as a default) on a credit asset. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes."

This is interesting stuff, how have we built such a house of cards? …